The US Department of Labor’s new “Investment Duties” rule: When implemented, proposal will limit the growth of ESG investment

Rick PasquierLegal Insights

The U.S. Department of Labor (the “DOL” or the “Department”) issued a release on June 30, 2020 in which it proposed amendments to the “Investment duties” rule under Title I of the Employee Retirement Income Security Act of 1974 (ERISA). Many early commentators believe that the practical effect of the proposed changes will be to discourage pension fund managers and advisors to those funds from selecting investments using criteria that that incorporate express environmental, social and governance (commonly known as “ESG”) considerations. The DOL states that it is taking action to uphold “bedrock principles” under ERISA that require fiduciaries to act with “complete and undivided loyalty to the beneficiaries,” a formulation of the fiduciary duty that is the “highest known to the law.” According to the proposing release (the “Release”), the DOL is taking these steps to protect retirees and prospective retirees from fiduciaries who might be tempted to use ESG as a screen behind which to make decisions that could harm them. 

Well-advised fund managers will be able find ways to continue to invest in ESG vehicles despite the new rule’s requirements. Including ESG investments in pensions subject to ERISA are not forbidden by the proposed rule. Investment managers and advisers will need to defend their choice of ESG investment strategies as being driven solely by “pecuniary factors” and “material economic considerations.” Fiduciaries in the pension and self-directed retirement plan arena will need to carefully weigh the risks of ESG investing and take steps to improve record-keeping to document more thoroughly the methods by which they decide on such investments. 

Comments on the proposal are due by July 30, 2020.

Brief Summary of the New Rule

The DOL explains in the Release that the new rule is essentially designed to “restate” existing law and clear up inconsistencies in sub-regulatory guidance. The proposed rule restates the statutory language of the “exclusive purpose” requirements and the “prudence duty” of ERISA.  

The proposed rule also provides additional gloss on the “core principles” behind the exclusive purpose requirement that fiduciaries not act to subordinate the interests of participants or beneficiaries to their own or another’s interests. Investments and investment courses of action need to be evaluated solely on the basis of “pecuniary factors and not on the basis of any non-pecuniary factor.” Furthermore, the fiduciary must not:

subordinat[e] the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to unrelated objectives, or sacrifice[e] investment return or tak[e] additional risk to promote goals unrelated to those financial interests of the plan’s participants and beneficiaries or the purposes of the plan.”

The proposed rule defines what it means to give “appropriate consideration” to the various facts and circumstances. The proposed definition makes clear, consistent with past guidance, that “appropriate consideration” must weigh how a particular investment fits into the purposes of the plan, including how the level of diversification, degree of liquidity and potential risk and return, and assess “how an investment course of action compares to available alternative investments or investment courses of action” related to these factors. 

The proposed rule provides new language that specifically addresses ESG factors. Use of ESG factors cannot result in selecting an investment that does not offer “pecuniary” advantages to the participant or beneficiary, either in the sense of having worse prospects for financial returns or involving additional risks above those of similar investments where ESG factors are not considered. The Release explains that “a fiduciary’s evaluation of an investment must be focused only on pecuniary factors.” Further, the proposed rule states that:

“Plan fiduciaries are not permitted to sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals. Environmental, social corporate governance, or other similarly oriented considerations are pecuniary factors only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.”

The DOL does not propose to repeal guidance dating back to 1994 to the effect that ESG factors can be used to “break a tie” between investment options that have otherwise “like” prospects for financial returns and risk profiles. The Release rule nevertheless contains language expressing doubt as to whether these “ties” actually exist and seeking comments from the public that could help the DOL evaluate whether this hypothesized “tie-breaking” scenarios actually come to pass in the real world. The proposed rule imposes additional record-keeping requirements in cases where “non-pecuniary” factors are used to break ties to document why investments were determined to be “indistinguishable” and why the investment was chosen based on the “appropriate consideration” criteria. 

The proposed rule provides revised guidance on fiduciary standards for individual account plans like the typical defined contribution 401k plans where the participant picks among a select group of investment funds.  Fiduciaries must use only “objective” risk-return criteria in selecting and monitoring investment alternatives for the plan including any ESG-oriented investment alternatives.  The rule requires that individual account plan fiduciaries adequately document their selecting and monitoring of investment alternatives and prohibits ESG funds or strategies from being used as component of any default investment alternative (i.e., QDIAs) offered to those participants who make no affirmative selection.

Considerations for ERISA Advisers

If adopted as proposed, fiduciaries will obviously face additional record-keeping requirements related to ESG investing and will probably need to exclude from their portfolios funds that expressly pursue “non-pecuniary” goals such as “impact” funds. It would appear that fiduciaries can still invest in funds that use ESG factors to make investment decisions if their use is relevant for assessing material economic factors that are “pecuniary” within the meaning of the new rule.  

While the new rule spells out duties of fiduciaries with additional language, it is important to appreciate that the DOL views the new rule, in part, as a clarification – in other words, these standards are applicable to fiduciaries today. As a result, we believe it may be a good exercise for fiduciaries to assess their policies, procedures and practices to gain a better understanding of where they stand vis-à-vis these DOL expectations. Below are some matters that fund managers and fiduciaries should consider:

  1. ESG funds will need to reassess client disclosures with respect to the impact of ESG factors on financial returns and risks.   
  2. Pension fund trustees and investment advisors should modify communications to clients that desire to have exposure to funds that provide exposure to ESG.   
  3. Fund managers may need to review their investment analyses and techniques to consider whether the use of “negative screens” may not be compatible with their client’s obligations.  A similar analysis would have to be considered with respect to “positive screens.”    
  4. Funds that fully “integrate” ESG factors into their selection process will need to take care to emphasize the role that these factors play in better assessing the material economic factors that are pecuniary in nature.
  5. Funds that focus on governance (“G”) will need to sharpen their justification for how better governance impacts long-term performance.  
  6. Fund sponsors can also expect that fiduciaries will more closely scrutinize how funds use third-party rating services to rank investments based on ESG factors.  Each third-party rating service uses ESG factors a bit differently, meaning that one may issue very different scoring results for the same corporate issuers than another.  This variability makes third-party rankings vulnerable to the criticism they are inherently “subjective” and thus excessive reliance on them raise significant issues under the proposed rule.

Please talk one of our experienced lawyers at Practus LLP to make sure that your investment methodologies and your management processes are able to cope with the additional scrutiny that the DOL may apply to use of so-called “non-pecuniary factors” such as ESG. We have the experience and the knowledge to help you navigate these choppy waters and help you develop cost-effective solutions.  

Those who want to learn more about my views about how this new rule may impact the larger movement toward “sustainable investing” and “sustainable finance” should check out my article published at Medium.com